6 Structured Products Flashcards
What is the Put-Call Parity Equation
Stock (Asset) + Put = Bond + Call
Collar =
Buy Put, Sell Call
The value of a levered firm’s risky debt is equivalent to owning a RISKLESS BOND and SELLING a PUT OPTION on the firm’s assets. At maturity, this may be expressed as:
K - max(K - V(T), 0)
The equity value of a levered firm is equivalent to a LONG CALL on FIRM’S ASSETS. The value of a call on the firm’s assets is the greater of zero and the difference between the value of the firm’s assets (V) and the face value of debt. At the debt’s maturity date, this may be expressed as:
max(V(T) - K, 0)
option positions corresponds to the mezzanine tranche of a collateralized debt obligation?
- Mezzanine tranche is similar to Collar (i.e., long asset + short call + long put with lower strike)
- Bull call spread (i.e., long call with lower strike + short call with higher strike)
- Bull put spread (i.e., long put with lower strike + short put with higher strike)
In Merton’s structural approach to pricing credit risk, the value of a firm’s equity and risky debt may be viewed in terms of which of the following options?
In Merton’s structural model, the firm’s equity value is viewed as a long call on the firm’s assets and the firm’s risky debt value is viewed as the value of a riskless bond and the payoff from a short put option on the firm’s assets.
CMO repayment sequence
Pays interest for all, then principal
How to calculate CDO payout
- Senior tranches are paid first
- If yields go down, see if it impacts the senior tranches. It may only impact equity.
- Senior tranches paid in full whenever possible.
Bondholders hold
- ____ Vega exposure
- ____ put option position
short
Debt of levered firm =
Riskless bond - Put
or Put = Riskless bond - put
MERTON’s CALL option view of capital structure:
- Equity of levered firm =
- Firm’s debt =
- Equity of levered firm = Long call option on firm’s assets
- Firm’s debt = Long assets + short call on assets (covered call)
MERTON’s PUT option view of capital structure:
- Debt of levered firm =
- Debt of levered firm = Riskless bond - Put on assets
Put option represents market price for bearing firm’s credit risk
Put option represents equity owner’s ability to put firm’s assets to debt holders by declaring bankruptcy
If firm performs poorly, debt holders suffer losses since they must pay stockholders a strike = value of the diskless bond
Value of levered firm:
Asset = Equity + Debt
Asset = Bond + Call - Put
Detachment point in CDO
highest percentage loss in the collateral pool that completely wipe out the tranche
Main difference between a total return swap and a credit default swap
The main difference between a total return swap and a credit default swap (CDS) is how payments are made.
- With a total return swap, payments reflect changes in the market value of the underlying credit-risky asset.
- With a CDS, the payment is made only if a predetermined credit event happens.
Describe the cash flows for the credit protection seller of a total return swap
Receive: total return on risky asset
Pay: fixed, periodic payment
Sumen, Inc.’s one-year zero-coupon bond yields 6.8% per year. It is estimated that the bond’s recovery rate is 92% and its credit spread is 2.3%. Which of the following comes closest to the exact and approximate risk-neutral probability of default, respectively, attained using the reduced-form model?
REDUCED: S / (1-RR) = 0.023 / (1-0.92) = 0.2875
EXACT: Reduced / notional = 0.2875 / 1.068 = 0.2692
Which exposures do these CDS indices offer you exposure to:
1. CDX
2. iTraxx
CDX provides exposure to investment-grade companies in North America and emerging markets.
iTraxx provides exposure to companies in Europe, Asia, and Australia.
Qualifying Affliate Guarantee refers to
An obligation of a subsidiary of a CDS’s referenced entity, if the subsidiary is at least 50% owned by the referenced entity, that may be delivered by the credit protection BUYER to the credit protection SELLER in a CDS.
An investor sells 5-year protection using a credit default swap. A tightening in the default swap premium of the reference entity would result in
- Positive MTM
- Gain to Protection seller
Difference in cash flows between the following:
1. CDS
2. CLN
3. TRS
4. Credit Option
CDS: series of payments from buyer to seller
CLN/TRS: not a single payout
Credit Option: Single
The WARF measures the average credit rating of the CDO collateral or tranches?
Collateral
CDOs on demand
Single-tranche CDOs provide more customization of CDO terms for their investors compared to other types of CDOs. Therefore, they are often referred to as “CDOs on demand” or “bespoke CDOs.”
Calculating overcollateralisation
Total Assets / Senior Tranche